Insight Collection: Covid Resilience

Would-be commercial tenants no longer know whether to take on a new lease. Existing tenants are looking for ways to adjust arrangements with landlords in order to survive the impact of the recent lockdown. Could something reminiscent of the traditional turnover rent now be a way to pin rental levels to the performance of a tenant’s business, during a unique period of economic uncertainty?

Yes, but whereas historically, turnover structures would see a landlord share in the very good times with the tenant, we’ve now seen measures undertaken on a global scale which have had an unmatched negative effect on the performance of businesses with a necessary physical presence – cafes, bars, restaurants, and retail.

Whilst some sectors have thrived – data, hosting, and connectivity, as well as e-commerce and the tech industry – some others have seen their revenue decimated and through no fault of their own; not many businesses could have foreseen to protect themselves against the consequences of coronavirus.

Whilst we cautiously emerge from lockdown and do all that we can to avoid a second wave of the virus, the turnover rent approach could prove a useful tool, for both new and existing commercial tenants.

Traditionally, turnover structures would see a base level of rent paid (usually around 75-80% of the open market value), and a top-up element which would be a percentage of the tenant’s net turnover over a given time period – usually between 5-12%.

This would generally have to be in tandem with a landlord option to fall back on a full open market rent if turnover fell below a certain threshold, and in some specific cases, keep-open covenants by the tenant such that turnover could be optimised – obviously for the purposes of making life easier in the current circumstances, an ability for the landlord to do either of these things would defeat the object somewhat.

If we assume a period of zero turnover (no longer unthinkable), a base rent would at least provide the landlord with some degree of certainty of continued rental income, and some capacity to satisfy any related loan obligations and covenants. At the same time, the tenant might be cushioned from the very worst of any ongoing or renewed impact on its business.

But many businesses occupying commercial premises are no longer holding back in requesting full turnover rents across entire existing portfolios i.e. no base rent, solely a rent linked to turnover.

On the face of it, this will be hugely unpalatable to commercial landlords, but faced with the dual prospect of tenants that simply won’t survive if they must pay rent over and above a level linked in some way to their income, and a potentially pretty tough lettings market, turnover only structures might begin to look more feasible, perhaps even as a temporary measure.

A deferred rent structure in place alongside a wholesale turnover rent might soften the blow i.e. allow the tenant to pay a turnover-only rent, with a structure to claw back a perceived “shortfall” once certain conditions are met, or at a certain point in the term. These structures carry some risk in that there’s no guarantee the tenant will ever be able to pay the shortfall in the future, and if used, they should be carefully documented as to exactly how the shortfall will be calculated and with reference to which income figures, and when and how it is expected that any shortfall will be paid to the landlord.

And what else is there to look out for?

Turnover rent provisions in leases are reasonably complex, and the gathering and provision of evidence of turnover, as well as the potential professional verification or audit of calculations can be burdensome and costly. These calculations also have great potential to lead to dispute. Any party considering a turnover structure must take expert advice, and ensure that there is appropriate provision in the lease for dispute resolution.

The parties will also need to be clear on what is and is not regarded as turnover.

Traditionally, items such as VAT on goods, refunds or credits for returned or faulty goods, or allowances for exchanged or traded in goods, or customary discounts given by a tenant, would all be discounted for the purposes of calculating a net turnover. Tenants will be keen to carve out income from online sales too i.e. that not generated on the premises in question.

Implementation of a turnover rent would also be the time to consider re-tightening returns policies for goods sold – many retailers relaxed and extended these during the height of the lockdown, but when it comes to turnover rent estimates and calculations, good turnover visibility is important.

Whether agreeing new terms or amending existing ones (whether as temporary concessionary arrangements or via more permanent variations to leases), rent review and alienation provisions are also matters to consider.

How is any turnover rent, whether a temporary or permanent arrangement, to be treated on rent review? Will “usual” assignment and subletting provisions apply? Or, did the landlord envisage a turnover rent with one specific tenant in mind? If an assignee or subtenant coming into occupation on any basis remains a possibility, will the turnover rent provisions be suspended for all or part of the remainder of the term, and if so, what will the substitute rent be?

Lastly, the following should always be kept in mind if changes are being made to existing arrangements, whether they manifest as concessions or variations:

• the circumstance in which, and for how long any temporary arrangements apply;
• whether the operation of any break option could be frustrated by reason of payment of a reduced rent, however temporary;
• whether the parties’ successors in title are bound by any new arrangements;
• whether any guarantor needs to be a party to new documentation;
• whether any third-party consents are required, from lenders or superior landlords or the like;
• rent deposit arrangements, and whether they can be drawn upon if a turnover rent produces a perceived shortfall as against the usual full rent; and
• where changes to existing leases amount to a variation, always seek tax advice particularly that pertaining to Stamp Duty Land Tax.